The TIPS-Treasury Bond Puzzle

The Treasury could save that money by buying back TIPS, entering into inflation swaps, and issuing Treasury bonds with the same maturity instead.

Treasury Inflation-Protected Securities (TIPS) are obligations issued by the U.S. Treasury, similar in most respects to Treasury bonds except that the principal amount of a TIPS issue is inflation-indexed -- that is, it is adjusted over time to reflect changes in the consumer price index. The Treasury began issuing TIPS in 1997.

With a type of arbitrage strategy, investors can convert the inflation-linked cash flows from a TIPS issue into fixed cash flows using inflation swaps. The resulting cash flows can then be structured to match the cash flows from a Treasury bond with the same maturity date as the TIPS issue, which results in straight-forward arbitrage profit opportunities that are greater than the costs of the transaction.

In Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle (NBER Working Paper No. 16358), authors Matthias Fleckenstein, Francis Longstaff, and Hanno Lustig show that the price of a Treasury bond and an inflation-swapped TIPS issue that exactly replicates the cash flows of the Treasury bond can differ by more than $20 (per $100 notional), with Treasury bonds almost always overvalued relative to TIPS. The total differential, they estimate, has exceeded $56 billion, or nearly 8 percent of the total amount of TIPS outstanding.

This mismatch in TIPS–Treasury pricing is strongly related to supply factors, such as Treasury debt issuance and the availability of collateral in the financial markets, and is correlated with other types of fixed-income arbitrages. However, this study raises the issue of why the Treasury issues TIPS, since in so doing it both gives up a valuable fiscal hedging option and leaves large amounts of money on the table. The authors contend that the Treasury could save that money by buying back TIPS, entering into inflation swaps, and issuing Treasury bonds with the same maturity instead.

The analysis here is based on a review of daily prices for 29 matched-maturity pairs of TIPS issues and Treasury bonds for the 64-month period from July 2004 to November 2009.

-- Frank Byrt

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